Worker Classification and Section 530 Relief
Employers are required to pay employment taxes to the IRS.
Generally, these payments consist of two portions: the
employee’s portion of FICA and income taxes and the
employer’s portion of FICA and unemployment (FUTA) taxes.
Employers who fail to timely remit employment taxes to the IRS run
the risk of being held liable for not only the employment taxes,
but also penalties and interest for late payment.
But independent contractors are treated
differently than employees. Specifically, if a worker is properly
characterized as an independent contractor (as opposed to an
employee), the taxpayer making payment to the independent
contractor is not required to remit payment to the IRS. Rather, the
independent contractor-particularly in the case of an individual
sole proprietorship-pays self-employment taxes on the
business’s net income.
Because of the distinction, taxpayers generally prefer to treat
their workers as independent contractors. Conversely, the workers
prefer employee treatment. In most instances, the tie will go the
taxpayer-payor, though, because the payor has more leverage over
the characterization of the worker as an independent contractor or
employee. That is, at least via contract.
Of course, the IRS is well aware of taxpayers’ general
inclinations to treat their workers as independent contractors.
Congress is too. Accordingly, under federal tax law, the IRS has
the authority to recharacterize workers as employees, even if the
two agree that they should be treated as independent
contractors.
Taxpayers in these situations are not without defenses. Although
there are many, a common defense that may be raised is Section 530
relief. To the extent a taxpayer can convince the IRS Section 530
relief applies, the taxpayer can avoid costly employment taxes.
Moreover, the taxpayer can continue to treat their workers as
independent contractors. A brief summary of Section 530 relief is
discussed below.
Common Law Factors (Employee v. Independent Contractor
Prior to getting into Section 530 relief, it is important to
understand the difference between an employee and an independent
contractor. Under federal tax law, the term “employee” is
defined to include “any individual who, under the usual common
law rules applicable in determining the employer-employee
relationship, has the status as an employee.”1 The
common law test looks at a multitude of factors-none necessarily
determinative-as a means to analyze the relationship between the
taxpayer and the worker.
The governing regulations provide additional color on the
characterization of a worker as an employee or independent
contractor. Under those regulations, the primary factor in
determining whether a worker is an employee or an independent
contractor is the extent of control the payor has over the work
performed.2 However, federal tax law also look at other
factors, such as: (1) which party invests in the facilities used in
the work; (2) the opportunity of the worker to make a profit or
loss; (3) whether or not the principal has the right to discharge
the individual; (4) whether the work is part of the principal’s
regular business; (5) the permanency of the relationship; and (6)
the relationship the parties believe they are
creating.3
Section 530 Relief.
Since 1978, Congress has provided so-called Section 530 relief
to taxpayers who meet all of its requirements.4 These
requirements include: (1) the consistency requirement; (2) the
historic treatment requirement; and (3) the reasonable basis
requirement. Each of these requirements is discussed in turn
below.
Reporting Consistency Requirement.
The reporting consistency requirement looks at whether the
taxpayer has consistently reported the worker as an independent
contractor. Accordingly, the IRS looks at whether the taxpayer has
issued Forms 1099 each year to the worker or group of
workers.5 Although some courts have disagreed, the IRS
also contends that the Forms 1099 must have been filed timely to
satisfy this requirement.
Historic Treatment Requirement
Under the historic treatment requirement, the taxpayer must not
have treated an individual (or individuals in substantially similar
roles) as an employee for any period beginning after December 31,
1977. To the extent the taxpayer has treated certain workers as
employees, Section 530 relief does not apply.
Reasonable Basis Requirement.
In many cases, taxpayers can sufficiently show compliance with
the reporting consistency and historic treatment requirements.
However, the third requirement-the catch-all reasonable basis
requirement-tends to be a more difficult sell for taxpayers to make
to the IRS. The safe harbors and the catch-all reasonable basis
standard are discussed below.
Safe Harbors and Other Reasonable Basis Standard.
The legislative history of Section 530 provides taxpayers with
some help in satisfying their burden of proof in showing reasonable
basis. Specifically, that legislative history indicates that the
reasonable basis requirement should be construed
“liberally” in favor of taxpayers.6 Although
the standard is a helpful one, the taxpayer still has the initial
burden to show relief. Moreover, taxpayers should be cautious that
under many of the reasonable basis standards, the IRS and federal
courts will not permit taxpayers to use “after-the-fact”
reliance arguments.7 That is, in some instances, the
taxpayer must show that they were aware of and relied upon the
factors prior to making a determination to treat the
workers at issue as independent contractors.
Judicial Precedent, Published Rulings, Technical Advice, or a
Letter Ruling.
The first safe harbor is reliance on certain federal tax
authority. A taxpayer meets this requirement if the taxpayer can
show reliance on judicial decisions and/or IRS published rulings,
provided the facts in those tax authorities are substantially the
same as the facts under audit.8 A taxpayer also meets
this safe harbor requirement if the taxpayer received technical
advice or a letter ruling from the IRS regarding the worker
determination.9
Prior IRS Audit.
The second safe harbor applies if the taxpayer can show: (1) the
IRS previously audited the taxpayer; (2) the IRS determined in that
prior audit that the taxpayer’s workers were independent
contractors; (3) the workers subject to the prior audit were
substantially similar to the workers at issue; and (4) the taxpayer
treated the two groups of workers in a substantially similar
fashion.10 Generally, an audit occurs when the IRS, at a
minimum, looks at the taxpayer’s books and
records.11
Long-Standing Industry Practice
The third safe harbor applies if the taxpayer can show a
long-standing industry practice. More specifically, the taxpayer
must show that: (1) a long-standing recognized industry practice
exists in a significant segment of the industry; and (2) the
taxpayer reasonably relied on this practice in the tax treatment of
its workers.12 For these purposes, a significant segment
does not mean a majority-rather, “one or two businesses may
constitute a significant segment of an industry.”13
A number of taxpayer-friendly rules apply under this safe harbor,
particularly because the evidentiary burden on the taxpayer is
perhaps the greatest under this safe harbor.
“Catch-All” Reasonable Basis.
In many instances, a taxpayer will not fall under any of the
safe harbors. If this occurs, the taxpayer will need to persuade
the IRS that the catch-all reasonable basis standard applies.
Although this standard considers almost any relevant factor, it is
often the most difficult of the standards to have the IRS agree
upon.14 Accordingly, taxpayers who intend to rely on
this factor should ensure that they properly set forth their
arguments and supporting facts to the IRS.
Relief from Improperly Classifying Workers
Used appropriately, Section 530 relief is a powerful
taxpayer-friendly rule in disputed worker classification issues
with the IRS. However, Section 530 is not an easy statute to
understand. Aside from the above matters, which have only been
discussed briefly, Section 530 contains a litany of other complex
procedural matters, including proper timing to raise the defense,
proper presentment of evidence, and certain burden-shifting
mechanisms. To the extent the taxpayer properly utilizes Section
530, though, the taxpayer can substantially reduce its exposure to
several years of employment taxes and subsequent treatment of
workers as employees.
Foototes
1 26 U.S.C. § 3121(d)(2).
2 See Treas. Reg. §§ 31.3121(d)(1) (FICA);
31.3306(i)-1 (FUTA); see also Peno Trucking, Inc. v.
Comm’r, 296 Fed. Appx. 449 (6th Cir. 2008).
3 Peno Trucking, Inc., 296 Fed. Appx. At 456, and cases
cited therein.
4 Revenue Act of 1978, Pub. L. No. 95-600.
5 See, e.g., CCA 200948043 (noting that issuing a Form
W-2 to a worker would be inconsistent with claiming the worker as
an independent contractor).
6 See H.R. Rep. No. 1748, 95th Cong., 2d Sess. 5,
1978-3 C.B. (Vol. 1) 629, 633.
7 See, e.g., 303 West 42nd St. Enters. v. IRS, 181 F.3d
272, 277 (2d Cir. 1999 (focusing analysis on whether the taxpayer
“in fact relied on” the grounds alleged); Nu-Look
Design Inc. v. Comm’r, 85 T.C.M. (CCH) 927 (2003)
(“The statute does not countenance ex post facto
justification.”); Veterinary Surgical Consultants, P.C. v.
Comm’r, 85 T.C.M. (CCH) 901 (2003) (courts must apply
Section 530 relief when “the taxpayer . . . relied on the
alleged authority . . . at the time the employment decisions were
being made.”).
8 See CCA 200948043 (“As to judicial precedent or
published rulings, the Service will look to whether the facts of
the judicial precedent or published rulings are sufficiently
similar to the taxpayer’s facts.”).
9 See CCA 200948043 (noting that PLR and TAM do not
provide a safe harbor to the taxpayer in question because those
were issued to other taxpayers).
10 See Smokey Mountain Secrets, Inc. v. U.S., 910 F.
Supp. 1316, 1325 (E.D. Tenn. 1995) (citing Lambert’s
Nursery and Landscaping, Inc. v. U.S., 894 F.2d 154, 156 (5th
Cir. 1990).
11 Conference Report, H.R. Rep. No. 104-737, 104th Cong., 2d
Sess., at 200 (1996).
12 Texture Source, Inc. v. U.S., 851 F. Supp. 2d 1260,
1265 (D. Nev. 2012).
13 Hospital Resource Personnel, Inc. v. U.S., 68 F.3d
421, 427 (11th Cir. 1995).
14 See, e.g., Nelly Home Care, Inc. v. United States Nelly,
LLC, 185 F. Supp.3d 653 (E.D. Penn. 2016); see also
H. Rep. No. 1748, 95th Cong., 2d Sess. 5, reprinted in
1978-3 C.B. 629, 632-33 (noting that Section 530 was intended to
“grant( ) relief if a taxpayer had any reasonable basis for
treating workers as other than employees.”); CCA 200948043
(“A taxpayer who fails to meet any of the three safe harbors
may nevertheless be entitled to relief if the taxpayer can
demonstrate, in some manner, a reasonable basis for not treating
the individual as an employee.”).
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.